Davis Freeberg on Today’s Netflix Analyst Call

Editor’s note: Davis Freeberg has joined me here at Thomas Hawk’s Digital Connection as a contributing writer. In addition to articles about the new digital lifestyle in general, Davis will also begin offering greater coverage of both TiVo and now Netflix. What follows is a report that Davis filed today on Netflix’s quarterly earnings and their follow up analyst conference call. Please join me in welcoming Davis to Thomas Hawk’s Digital Connection. Davis can be contacted directly at davisfreeberg@thomashawk.com. By way of disclosure regarding the article below, Davis is currently a Netflix subscriber as well as a current Netflix shareholder.

by Davis Freeberg, Contributing Writer

Netflix has been an interesting company to follow. After seeing two years of blistering growth in their stock, investors have become more cautious over the last six months about the company’s future. Much of the fear surrounding Netflix stems from competition that they face from Blockbuster, Amazon.com and even more significantly, the holy grail of Media, VOD (Video on Demand).

Reed Hastings, Netflix’s CEO and Co-Founder spoke this afternoon about his company and their prospects in the upcoming months.

Ultimately, Hastings sees the overall market for online DVD rentals increasing to 10 – 20 million subscribers by 2010. During the conference call, Hastings tried to reassure shareholders of the significance of DVDs. Hastings pointed out that Disney makes more money selling DVDs than Comcast makes entirely as a company.

According to Hastings, at the recent NCTA Cable conference a number of media executives expressed their support for the DVD market over Video on Demand. Given that the entertainment industry is making significant capital expenditures on HDDVD Hastings may have an accurate point about the entertainment industry’s preference for DVDs over VOD.

Although the entertainment industry may make more money per sale selling DVDs than VOD, I know that I personally would prefer High Definition Video on Demand over online DVD’s any day of the week. I suspect that most other consumers would feel this way as well.

Generally speaking, the media industry as a whole is not interested in allowing VOD to prosper. They very well may need to be dragged into it kicking and screaming perhaps much like the music industry was forced to the table on digital music downloads. The margins on DVD sales are simply too fat to allow for the ultimate everything on demand solution.

While consumers have no problem shelling out cash to buy a DVD, people would never pay $20 to “buy” a VOD view. In the same way that it took the adoption of Napster and Kazaa to convince the Media Industry to allow iTunes and other online mp3 sites, the recent development of video and audio podcasting, DVRs and BitTorrent technology should ultimately force the Media industry to embrace new VOD technology. The real question is whether this buys Netflix 5 – 10 years like Hastings suggests or whether the company will be forced to innovate more quickly. Hopefully the later.

In looking through Netflix’s numbers, it is a little concerning that only 4.6% of their revenue is used for technological development. In many ways the DVD rental market is a lot like the Dial Up ISP market of yesteryear. Just like AOL has failed to address the systemic loss of subscribers to broadband access, Netflix faces a situation where, without the right capital investments and media partnerships, they could ultimately become outdated and irrelevant before they ever even see a 10 year anniversary as a business.

As more consumers embrace alternative forms of entertainment, DVRs and ultimately VOD, Netflix will be forced to transition from a distribution center to a content aggregator and provider.

During the call, Hastings suggested that he sees the DVD market developing into a two company market which should result in higher margins. If this turns out to be the case, then it bodes well for Netflix in the short run. Blockbuster has had significant issues with customer satisfaction, controversy surrounding censorship, lawsuits for false advertising and hostile shareholders Blockbuster has contractually committed to keeping their prices at current levels until at least January of 2006, but there is definitely shareholder pressure on Blockbuster to limit the amount of money and resources that they spend on their online service.

Contrast this to Hastings’ view that “current Netflix subscribers are great evangelists for our service.”

I would go a step further and say that not only are the Netflix customers evangelists, but that management feels as passionately about what they are doing themselves. Hastings originally created Netflix after Blockbuster charged him a $40 late fee.  It’s personal. Also positive to note of late is that we have recently seen an increase in insider stock acquisition.

One wild card that is still out there is whether a deal with Amazon might be around the corner. During the call, Gordon Hodge with Thomas Weisel Partners asked about the speculation that Amazon could ultimately team up with Netflix or with Blockbuster. As you would expect the company offered no comment.

Hastings did seem very adamant, however, that in the future it will be a two competitor system. This may help to fuel speculation that Amazon will ultimately outsource their DVD rental program. If Hastings is correct and Amazon ultimately hires Netflix or Blockbuster as a distribution partner, then it’s possible that we could see prices increase next January. During the call Hastings alluded that if Amazon chooses to enter as a competitor, then the current price war will continue.

What was most impressive about Netflix’s call was their significant subscriber growth. They were able to add 408,000 net subscribers during the quarter, but did so at greater subscriber acquisition costs and a greater churn rate, then previously experienced. On the call, Hastings pointed out that “despite Blockbuster’s aggressive pricing, in-store promotions and TV advertising, Netflix still generated a record number of gross subscriber additions.”

While Netflix decided to suspend future subscriber guidance, if they can continue adding subscribers at this pace, they should easily hit 10 million subscribers by 2010. Interestingly enough, Hasting recently made suggestions that once Netflix reaches 10 – 20 million subscribers, he sees the company transitioning to an independent production studio similar to HBO.

During the call, Netflix heavily promoted their new lower price / less DVD options as being an important aspect to their future growth. Because their margins are the same at the $9.99 level as they are at the $17.99 level, Hastings seemed to feel that Netflix would be “agnostic” about which plan consumers choose. They plan on using the $9.99 price level to attract more mainstream adopters and feel that they can return to profitability by the third and fourth quarter of this year.

Netflix expects to have free cash flow beginning this quarter, however they did forecast an earnings loss of $2.2 – $7.2 million for the second quarter. This is due t
o their commitment to increased marketing costs in the wake of Blockbuster’s current ad campaign.

Hastings pointed out that one reason for the heavy promotion of the new $9.99 plan is that “the fewer DVDs that you have at home, the more important it becomes for a company like us to ship you DVDs on time.” This helps to “shift the playing field a little bit in a way that will be advantages to Netflix.” This could help to provide a clearer differentiation between services.

Currently, Netflix has 31 distribution centers and 90% of their customers receive their DVDs overnight.

The two biggest issues that weren’t addressed on the call were Netflix’s current short position and their relationship with TiVo.

Currently, Netflix has 15 million shares (with approximately 45 million shares trading in the market) that are shorted (shares that have been sold by people who don’t own the stock and must buy it back at a later date.) While this number isn’t as high as the 22 million share short position they had in November, it does make me wonder. Who would short a growing company, in a growing industry with enough cash on hand to stay alive for a very long time (approximately $170 Million)?

Given the current proliferation of hedge funds, it’s hard to determine if an increase in their stock price would scare short sellers into buying or if it would have no effect on the stock. You can call me a conspiracy theorist if you would like, but I find it hard believe that your average stock consumer is sophisticated enough to short a stock like Netflix. Could it be that the Media industry or possibly a competitor is trying to artificially keep the price of their stock low or is this simply a reflection of shareholder concerns over their current price war? Either way, just like we have reportable events for companies and individuals that are long large stock positions, the regulators should consider regulations that require large short holders to report when they buy or sell as well.

As an avid technology proponent, I found Hastings lack of comments about VOD as well as their previous announced relationship with TiVo very disappointing. I’ve been waiting for everything on demand for a very long time and for them not to address their partnership with TiVo was a bad sign for major media VOD.

Also, with TiVo’s most recent partnership with Comcast, one can’t help but wonder if Tivoflix is dead in the water at this point. It’s hard to imagine a scenario where Comcast, Time Warner or Cox would allow a partner to sell VOD.

Currently, Microsoft offers VOD via their Window’s Media Center through Cinema Now and Movielink, but it’s unclear as to how well it’s been embraced by customers. One issue is that the picture quality is nowhere near as good as DVD or HDTV.

As the DVD market transforms into a VOD market, cable will ultimately be the real competition with Netflix not Blockbuster. Their ability to innovate, partner and bring VOD to the mass markets, will determine whether this company will ultimately succeed or fail. They may make money today pursuing a DVD mail delivery strategy but it is imperative that they also develop a better longer-term game plan.

2 Comments

Take this with a grain of salt since I admittedly work for a company called DVD Station http://www.dvdstation.com which is in nomenclature and operating model not a VOD play but is a strong believer in packaged media.

Although, we agree the value proposition of VOD and especially HDVOD is undeniably compelling (in the long run it seems that is must win), here are some quick thoughts on why we’re still bullish on packaged media:

A typical Blockbuster distributes 16 terabytes of data a week via DVD. Granted the standard DVD format is based upon an old codec and can be compressed nearly 6-fold with nominal degradation in quality, but the HDDVD formats will be built with better codecs and will carry 3 to 9 times the data. With 8,000 locations, Blockbuster will be moving many petabytes of data weekly. Consumers may trade viewing quality and viewing selection for convenience but bandwidth costs alone (even with P2P)shouldn’t be overlooked, Reed Hastings could probably provide a perspective on the bandwidth costs for them to replicate their service via VOD vs. their sneakernet. Simple server storage for the data contained on 30,000 films would cost millions annually whereas one could store 30,000 DVDs in a small unrefrigerated closet.

Veronis Suhler, Adams Media Research, and ABN Amro seem to concur that over $300BB will be spent on packaged digital entertainment between now and 2010 and that the estimates for VOD are closer to $10BB (a rounding error) over the same time horizon. They could be horribly wrong but they’d have to be to ignore continued double digit growth in the multi-billion dollar market for packaged media.

The studios and electronics companies are making multi-billion dollar bets on building the next-generation platform for packaged media, they could be horribly wrong but since the studios also hold the IP, their views and bets shouldn’t be entirely dismissed.

VOD is no doubt sexier and will create new distribution channels, new publishers, and some very valuable tech company enablers but placing 17 gigabytes on a piece of plastic that costs $.20, that has strong DRM protections, easy portability (share with friends, play in car, get from a laptop to TV in seconds), near flawless data transfers,etc. etc. is no small feat. Perhaps it only has a 10-year life but, our belief is that it will take Starbucks 50 years to equal the dollars spent on packaged media over that time period and it will accomplish this with much, much lower margins.

Compression algorithms will get better, bandwidith and storage costs will make exponential leaps, technologies currently undreamed of will emerge but for the next decade we’re placing a big bet on little plastic disks and several small bets on alternative platforms (personal media player downloads, flash-based storage downloads, and others).